War Veteran’s Fund Losses Explain Glass-Steagall

Dec. 7 (Bloomberg) -- One of the great debates to emerge
from the financial crisis is whether the U.S. Congress should
resurrect some form of the Depression-era Glass-Steagall Act and
bring back the separation of commercial and investment banking.
It should, but not for the reasons usually cited.

Put aside the tired arguments about whether the law’s
repeal in 1999 caused the crisis. It did help banks deemed too
big to fail get larger, but the crisis had no single proximate
cause. We would have systemically dangerous financial
institutions even if the law had stayed in place.

There’s a better argument for separating securities firms
from commercial banks: to protect consumers. The banking
industry has a long history of preying on unsophisticated
depositors by selling them garbage investments without regard to
suitability. This was a big reason Glass-Steagall was originally
enacted.

Consider the $61 billion in settlements between large banks
and the Securities and Exchange Commission over sales of
auction-rate securities, the market for which collapsed in early
2008. Citigroup Inc., Bank of America Corp. and other banks told
customers the securities were safe, highly liquid investments
comparable to money-market funds. They weren’t.

Cross Selling

At Wachovia Corp., the SEC said bank employees helped
recruit retail depositors for the investments. Wachovia, which
was bought by Wells Fargo & Co. in 2008, later agreed to
repurchase $7 billion of the securities. Regulators in
Washington state made similar findings about Wells Fargo as part
of a $1.3 billion settlement in 2009, saying the bank and its
investment divisions “engaged in cross-selling in connection
with ARS sales.”

Cross-selling junk to mom and pop depositors wasn’t limited
to auction-rate securities. Last year the Memphis, Tennessee-based brokerage Morgan Keegan & Co. agreed to a $200 million
settlement with state and federal securities regulators over
seven mutual funds that lost $1.5 billion in 2007 and 2008.
Morgan Keegan brokers sold the proprietary bond funds to more
than 30,000 account holders. The SEC said the funds’ managers
mismarked their asset values.

Morgan Keegan, then a subsidiary of Regions Financial
Corp., “targeted Regions Bank depository customers with
maturing certificates of deposits or other depository assets,”
the Alabama Securities Commission and other state regulators
said in their complaint. “More money could be made on broker-dealer fees than on the interest spread on interest-bearing
deposits.”

One of those customers was Donald G. Smith, 66, who owns an
auto-repair business in Hot Springs, Arkansas. Several years
ago, he and his wife had a $96,000 Treasury bond. After it
matured, he said a Regions financial adviser sent him to see a
Morgan Keegan broker in the same branch.

He put the money in the funds the broker recommended, which
soon crashed. The funds’ holdings included complex instruments
with names like synthetic collateralized debt obligations,
first-loss pieces and pooled trust preferred securities. Smith,
a Vietnam War veteran and former oilfield worker, said he isn’t
a sophisticated investor. His last year of school was eighth
grade.

“I told her this was our nest egg, and we couldn’t afford
to lose it,” he said, referring to the Morgan Keegan broker.
Why did he trust Morgan Keegan? “It was right there inside the
bank. One employee that I had trusted recommended me to another
one.”

After the Smiths filed claims against Morgan Keegan, a
securities-industry arbitration panel in August awarded them
about $11,000, after hearings fees, which was a small fraction
of their losses.

Wealth Destruction

Their experience is reminiscent of a story about another
bank customer: Edgar D. Brown, of Pottsville, Pennsylvania. His
testimony at the 1933 Senate Banking Committee hearings on the
1929 stock market crash was recounted in Michael Perino’s
acclaimed book, “The Hellhound of Wall Street,” about the
committee’s chief counsel, Ferdinand Pecora.

In 1927, Brown responded to an advertisement by City Bank
(now Citigroup) offering to help with financial advice. Brown,
who had $100,000 in cash and government bonds from selling a
theater chain, received a reply from a salesman at National City
Co., City Bank’s securities affiliate.

The salesman said Brown should sell the bonds, borrow two
or three times the money he had, and invest in securities the
company recommended. “Brown took the company’s advice,
insisting only that he wanted bonds instead of stock,” Perino
wrote. “Other than that Brown trusted the company implicitly.”

Perino wrote: “Over the next year a welter of bonds came
in and out of Brown’s portfolio. There were railroad bonds,
utility bonds, and industrial bonds. Brown’s foreign bond
holdings spanned the globe -- Peruvian and Chilean bonds; bonds
from the State of Rio Grande do Sul in Brazil; Vienna and
Budapest bonds; the bonds of the Belgian National Railroad,
Norwegian Hydro, German General Electric, and the Saxon Public
Works; Greek, Italian, and Irish bonds. They seemed to have only
one thing in common -- they all went down in value.”

When Brown complained the next year, the salesman blamed
Brown for insisting upon bonds. So Brown took his advice to buy
stocks. “I bought,” Brown testified, “thousands of shares of
stock on their suggestion which I did not know whether the
companies they represented made cake, candy or automobiles.”
Following the company’s advice was, he thought, “the only safe
thing to do.” In 1929, at age 40, he lost almost everything.

Brown’s testimony helped persuade Congress to pass Glass-Steagall that same year. It was a good idea at the time to
separate securities firms from commercial banks. It still is.

(Jonathan Weil is a Bloomberg View columnist. The opinions
expressed are his own.)